“Ask the Attorney” – Splitting Equity

by Scott Edward Walker on March 17th, 2010

Introduction

This post is part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”

I have two goals here: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain English (as opposed to legalese).  Please give me your feedback in the comments section.  Many thanks, Scott

Question

My two friends and I have been working on a new venture for almost a year.  Our site is in beta and we actually have a few customers (it’s a subscription-based model).  We’ve spoken to a lawyer about incorporating, but we don’t know how to split-up the stock.  Should everyone just get one-third?

Answer  

That’s a great question.  Before I answer it, however, let me just make a quick point:  When launching a venture, the first rule of thumb is to incorporate as soon as possible when the venture has as little value as possible.  Why?  Because, among other things, you want to be able to issue stock to the founders for a nominal purchase price so that they can share in the increased value of the company (and start the capital gains holding period).

To the extent the venture’s incorporation is delayed and its value increases due to the meeting of certain milestones, etc., there may be tricky tax issues with respect to the purchase price (or value) of the shares issued to the founders.  Indeed, if the company were ever audited, the IRS may take the position that the shares sold for a nominal purchase price actually had value and deem such value compensation to the founders (particularly if the shares were issued on a date close to a financing date).

As I have previously discussed, another important reason to incorporate as soon as possible is to protect against personal liability.

Now, with regard to your question whether the equity should be split equally, the short answer is “usually not.”  The splitting of equity is a significant business decision which must be negotiated among the founders based upon their respective contributions to date and their expectations going forward.  Simply dividing the shares equally among the three of you may sound fair on its face, but it’s usually not the correct decision.

Factors to consider include:

  1. Whether any of the founders contributed cash and/or intellectual property to the venture – which would warrant a higher percentage for that founder.
  2. Whether any of the founders actually came-up with the idea for the venture – which would warrant a higher percentage for that founder.
  3. Whether any of the founders will be working part-time or less than the other founders going forward – which would warrant a lower percentage for that founder.
  4. Whether any of the founders put in more time prior to the incorporation (e.g., created the prototype) or actually started the venture – which would warrant a higher percentage for that founder.
  5. Whether any of the founders will have greater responsibility or will be adding more value going forward than the other founders (e.g., due to domain expertise) – which would warrant a higher percentage for that founder.

The bottom line is that every venture is different, with varied contributions (past and future) by the founders.  It might help to sit down with your co-founders and your lawyer and hash this issue out.  As I discuss in my VentureBeat post regarding founder vesting, you will also need to hash out the vesting schedules, including (i) whether any founders will vest a portion of their stock “up front” and/or (ii) whether a  one-year “cliff” will be imposed on any founders.

Conclusion

I hope the foregoing is helpful.  There is an interesting post by Frank Demmler entitled “The Founders’ Pie Calculator,” which provides a way to quantify the elements of the decision-making process.

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